Why you need to be thoughtful when using a bank line of credit

Business owners use lines of credit to cover short-term working capital needs such as a payroll advance or a situation where you have to make an unexpected inventory purchase, says Joseph P. McNamee III, Vice President at Consumers National Bank’s Stow Business Lending Office.

“You just never know when an issue will arise where one of your customers doesn’t pay on time and you have a payroll file coming due,” McNamee says. “The rates on a line of credit are typically more advantageous than if you were to utilize a business credit card.”

The key to making good use of a bank line of credit is the ability to know when not to use it, McNamee says.

While it can help you manage your cash flow and handle unforeseen expenses, you should avoid using it to purchase equipment or to cover other potentially long-term debts.

“Those are not good uses for a working capital line of credit,” McNamee says. “Anything that you’ll need to make payments on for more than 12 months, you need to be looking at a long-term loan.”

Smart Business spoke with McNamee about how to secure the right line of credit to effectively manage your company’s working capital needs.

Why are long-term expenses a bad use for a line of credit?

Most banks have an aggressive clearing provision that they can enforce with this type of financing tool. If you borrow the full line amount to purchase a piece of equipment and your bank enforces the clearing provision — meaning that you need to pay the debt in full every 12 months — the effort to do so could hurt your cash flow when finances are tight.

That could become a serious issue if those unexpected expenses come into play. Let’s say you need to bolster your inventory or make an important equipment purchase and find that you can’t do it because your cash is tied up attempting to pay off your debt to the bank.

Cash flow is the lifeblood of a business and when you can’t access it, it can create big problems. You need to make sure you have access to cash when you need it, which is the purpose of a line of credit.

What’s the best approach when reaching out to your bank about obtaining a credit line for your company?

Schedule a meeting with your bank and determine if a line of credit is the best fit for your needs.

Your banker will typically want to go over your entire cash flow cycle and review financial statements and tax returns to determine your qualifications.

Before the meeting, you should gather business and personal tax returns from the past two years.

Collect your most recent financial statements, including a profit-and-loss report, your balance sheet, and accounts receivable and accounts payable aging reports, in addition to your own personal financial statements.

What if your company is concerned about its ability to secure a bank line of credit?

If you have a trusted business adviser who has worked with your company, have that person sit down with your bank and look over your financial portfolio together. It could be that you don’t qualify right now for a line of credit, but these conversations could lead to a strategy that puts you in a better situation to get a line of credit in six months or a year.

Banks work with many businesses and often there are challenges that need to be overcome. It is through this work that banks develop contacts with consultants and experts who can help your company get things turned around and back on track toward meeting your goals and growing your business. If you haven’t been able to develop this kind of partnership with your bank, look for someone who is passionate about helping clients grow their businesses.

What’s another tip for how to responsibly use your credit line?

Line of credit payments are primarily interest only. The onus is on the business owner to pay additional principal each month to pay down the debt. You don’t want to get into trouble by paying only interest each month and then playing catchup to pay and resolve your line of credit.

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